Reduce cash to maximise retirement income

"Although my fund investments are income rather than accumulation units, as I understand there is little practical difference," says Mr Edwards. "I intend to reinvest dividends and interest to buy more funds, and I also reinvest the dividends from my share holdings.

"I have about £120,000 in cash individual savings accounts (Isas) and saving accounts. The funds and shares I hold amount to just over £70,000. I am not sure what a suitable asset allocation for my circumstances is and would welcome advice.

"In the past I have been very risk averse but now I realise an element of risk is inevitable so now I do not get fazed out when some of the six equities I have bought this year are running at a loss. I understand that time in the market is important, especially for income investment. I am wondering whether more exposure to the US, emerging markets and developed Asia would be advisable. However, I would describe myself as cautious.

"I have come to investing very late in life - I wish I had started sooner but bad advice in 1999 led me to lose out on my first investments in four unit trusts."

SIMON EDWARDS' PORTFOLIO

Source: Investors Chronicle as at 7 February 2013

LATEST TRADES

■ Allianz European Equity Income A Acc (Sell)

■ F&C Managed Growth Fund Class 1 Acc (Sell)

■ Six funds outside Isa (Buy)

Chris Dillow, the Investors Chronicle's economist says:

You ask what would be a suitable asset allocation for your circumstances. We can test this by thinking about expected returns and risk. Your portfolio is pretty well diversified with a defensive bias, so as a working assumption, I'd expect a 4 per cent annual real return with a standard deviation of 15 percentage points - less than the properties of equities generally. This implies that, over five years, you have a roughly one-in-four chance of being worse off in real terms than you are now, but also a one-in-four chance of being 50 per cent better off. Do you fancy these probabilities?

One issue here is whether you will return to work. If you are able and willing to, then you're in a better position to take on equity risk, because if the market does badly, you can make up losses by working. If, however, you can't work, then you lack this cushion and so are more exposed.

If this is so - and if you don't like these odds - then you need some safer assets. I'd be wary of bond funds, as bond prices could well fall and not necessarily at the same time as equities rise. But you should consider either more cash - its return is poor, but safe - or some safer bonds that mature in five years' time. Of course, doing this will reduce your upside potential - but there is a trade-off between returns and safety.

You ask whether you should consider more exposure to the US, emerging markets and Asia. I'm in two minds here. On the one hand, international stock markets tend to rise and fall together, so any losses on your existing holdings would probably be accompanied by losses in those markets. On the other hand, if you want to take on a little more risk, these markets are a way of doing so, as they are likely to rise more in good times than your existing portfolio.

Should you want to do so, please consider tracker funds. Not only do they have lower fees, but their past performance is rather good, consistent with the idea that most active managers underperform.

There is, though, one mistake I want to warn you against. You say that "the market is important, especially for income investment". In one sense, this is not true. Please do not buy higher-yielding shares because you think they offer more income. In theory, income comes at a price; stocks have above-average yields because they have worse growth prospects or higher risk than average: Bradford & Bingley and Northern Rock, remember, offered a great income in 2007. The case for income stocks lies not in the fact that they pay a high income, but rather in the fact that investors have tended (on average) to under-price them and so they've offered better than average returns over the long run.

By all means buy a high yielder if you have reasons to think it cheap. But don't do so simply because you want an income. Remember, you can create your own income simply by selling shares. What matters is total return, not yield.

You say something else that intrigues me - that you no longer get fazed out if three of your six shares fall. Good. Please forget this silly way of thinking forever. Every investor who ever drew breath has lost on some of their positions. And everyone will continue to do so. In stock-picking, perfection is unattainable. What matters is your portfolio as a whole. As long as you have enough winners to offset the losers, you are ahead. And that's the best you can hope for.

Tim Cockerill, head of collectives at Rowan Dartington, says:

Your objective, time horizon and risk appetite are quite clear. Although income is not required now it will be in five years' time. In the past you have been quite cautious and this remains your inherent attitude towards risk but you appreciate that taking risk is a key element in achieving your goals.

You have a pension and so a 'solid income base' on which to build, however you need to estimate the income you will require when you fully retire. By estimating this it's possible to have a reasonably good idea of how much capital will be needed to generate that income and thereby the growth your current capital needs to achieve, which in turn informs the investment selection.

At present your assets are divided approximately one third invested, two thirds in cash. With interest rates staying low for the foreseeable future, cash holdings are going to contribute little to achieving your goals; in fact they will probably lose value in real terms if the interest earned is less than inflation. With inflation expected to rise over the next 12 to 24 months the potential for loss is all the more real. As a cautious investor it can be difficult to take money from a 'capital secure' investment and invest it in the market. However I would suggest as a guide and first step that two thirds should be invested and one third held as cash. One way to judge how much cash to hold is to base it on an amount equivalent to six months expenditure, so one third held as cash would still be cautious. Another factor to consider is whether you have plans for any major expenditure, for example, a new car or a holiday.Some rainy day money should be held too. When thinking about this it's important to remember that retiring at age 60 means the portfolio will have to keep producing income for many years, perhaps more thsan 30.

Your current portfolio consists mainly of good quality investments and has a sound regional split. Not all of the funds are income orientated but this is not too important at this stage. Exposure to Asia/Emerging Markets is more than usual for a cautious investor, but the funds are suitable long term investments. I would switch the Invesco Perpetual European Equity Fund (GB0033051334), which has been relatively poor within its sector to another, such as Blackrock European Dynamic (GB0000495209). Otherwise the equity funds held are solid for long-term growth. The three bond funds account for about 17 per cent of the current portfolio, but you should be aware that bonds are highly priced and downside risk is very evident, although unlikely to result in losses for a while yet. When the bond markets do correct they will still provide a dividend but the capital will suffer. Because of this I would suggest any new investment is in equities rather than bonds. Funds to consider would be Newton Global Higher Income (GB00B0MY6T00) and (IC Top 100 Fund) M&G Global Dividend (GB00B39R2M86). Both have quality management, are diversified globally and are income focused.

Read our tip on Newton Global Higher Income

Your six directly held equities have been selected for income, three of which are on our buy list, those which aren't are Aviva (European risk), National Grid (high levels of debt) and SSE (wind farm risk). Although these are large companies this is still a very concentrated portfolio. We would suggest a minimum of 25 stocks when investing directly to provide diversification. The recent problems at BG shows that large cap stocks are just as vulnerable to disappointments as any company and the losses can be painful. To address this any additional investment could be into more direct equities to provide diversification or you could look to move into a funds-only portfolio by selling these direct holdings at a suitable opportunity. Given your cautious nature I think funds would be more appropriate.

Investing for income now and reinvesting dividends makes sense because income provides a considerable part of the investment return over time. In five years you would then be able to switch to having the income paid out. This wouldn't disrupt the portfolio and would be very cost effective.